Floating Rate Swap & Market Value Risk

CFA Level III
#1

In Kaplan mock test, in one of the questions a client converts his fixed rate debt to floating rate debt. An analyst makes the following comment

“By entering into the swap, the absolute duration of Worth’s long-term liabilities will become smaller, causing the value of the firm’s equity to become more sensitive to changes in interest rates.”

Going by conventional understanding, synthetic floating rate swap should reduce the market value risk (and increase the CF risk). Low MV risk = lower volatility in equity. However, Kaplan has given the following explanation.

Currently, Worth is “matching” its balance sheet asset/liability durations by funding long-term fixed assets with fixed liabilities. This minimizes equity volatility. Entering a receive fixed/pay floating swap will reduce the absolute duration of the net liabilities on the balance sheet by creating synthetic floating rate debt. If interest rates decline as expected, the economic value of assets will rise faster than that of liabilities, raising the economic value of balance sheet equity. The equity is becoming more sensitive to changes in rates. (Study Session 15, LOS 28.b, c)

If even synthetic floating increases MV risk, then is it fair to conclude that either synthetic fixed or synthetic floating increases the MV risk. While CF risk is reduced with synthetic fixed swap?

#2

By locking into fixed rate SWAP exposure in BS on borrowings in floating rate is neutralized and further cash outflows regarding interest payments are more predictable and less volatile. However in scenario of IR decrease by locking into fixed rate payment SWAP, a company is exposed to Market value risk because of earnings deterioration and thus market value of company decreases in such scenario.

#3

In the swap context, MV is used to describe the economic value of equity on the balance sheet. Scheweser notes talks about the impact on the economic value on the balance sheet when floaging rate debt is converted to fixed rate. As per the notes, CF risk is reduced by MV risk is increased as now the debt is converte to fixed rate. As fixed rate debt has a higher duration than floating rate debt, it increases MV risk while reducing CF risk (more certain cash flow).

I am pretty clear on the synthetic fixed rate debt impact. That is, lower CF risk but higher MV risk.

I am not sure about the MV risk on the synthetic floating debt. From the Kaplan’s explanation, it seems that MV risk is increased regardless, which in a way does not seem logical.

#4

The explanation is as per above that equity in BS may become more volatile under both SWAP exposure and that’s it.

#5

Exacgly. That’s what I wanted to confirm. Thanks.